Banking Crises, Regulatory Reform and Resolution

1. Banking Crises, Regulatory Reform and Resolution Charles Calomiris May 11, 2010

2. Macroeconomics and Banking • View that banks are sources of shocks and propagators of shocks in the macroeconomy was “rediscovered” in 1980s, and has received more attention in the past decade, especially after the Asian and Mexican crises. • This view has substantial historical precedent, and supporting historical evidence, and is only “new” in the sense that it was ignored by most macroeconomists in 1950s, 1960s and 1970s.

3. Why the Rediscovery? • Banking instability became more of an issue in macroeconomics. • Key trends • Frequency of banking crises • Coinciding of banking crises/capital crunches with macroeconomic declines • Mixing of banking crises with exchange rate or sovereign crises.

4. EM Banks Especially Unstable • Fiscal costs of banking crises in EMs amounted to about $1 trillion in the 1980s and 1990s, which was equal to all foreign assistance transfers from developed countries from 1950-2001. • Many of these collapses also involve twin crises (collapses of both exchange rate and banking systems), with dire macroeconomic consequences. • Why is this happening? What can be done?

5. Central Questions about Bank Risk and Prudential Regulation • Why are crises so common and so severe now? • Are banking crises and their causes the same or different from those of the past? • Are crises inherent in the function and structure of banks? • Which supervision and regulation rules work? • Should government pursue counter-cyclical forbearance policies, or procyclical prudential regulation?

6. Bank Function and Structure • Banks control risk via intensive screening, contracting, and monitoring, involving private information production. • Bank function and structure • Delegated monitoring on asset side, liquidity creation on liability side • Maturity and liquidity transformation • First-come-first-served rule • Essential structure and function of banks has created a special role for debt market discipline of banks, in contrast to other firms. • Does this make banks risky? Does that explain EM banking crises? • Alternative view: Insider lending, moral hazard, politics of bailouts (Populism meets cronyism)

7. Crises have different shapes • Currency depreciation only, reflecting an overvaluation of the currency, but without effects on banking system • Brazil 1999: overvalued currency, lack of fiscal discipline, but banks relatively healthy, no resurrection risk betting • Banking collapse only • Australia 1893: costs of losses in banks absorbed by stockholders and depositors, not taxpayers • Twin crises, in which banking collapses and exchange rate collapses happen together. The new phenomenon of twin crises (only a handful were observed in pre-1980 era). But twin crises can also be distinguished according to the dominant direction of causation • fiscal crisis => banking instability as in Argentina 2001, where government lacked the safety valve of inflationary monetary policy, and thus stole bank capital as last resort means of financing; • or banking instability => fiscal crisis, as in Mexico 1994 and East Asia 1997, although in these cases there was also an overvaluation problem of real exchange rate, in Mexico because of boom in demand, and in Asia because of cumulative decline in productivity

8. Financial system feedback during crises Currency devaluation Rapid rise in interest rates Capital outflow Overextended banks and firms

9. Risk factors show themselves during crises • Law: inability to have orderly workout in financial distress leads to backlog of unresolved debts; reversal of privatization contracts, redenomination of contracts, limits on capital flows, nationalization of assets. • Information: markets react dramatically to crises (shut down of orderly information processing, high adverse selection costs) • Fiscal policy: lack of political will to reduce expenditures, improve tax collection, avoid inflation tax. • Banking: desire to protect bankers, who are often borrowers and political allies, too, leads to lack of credible discipline ex ante, and big bailouts ex post. Quasi privatization can be worse than public banks from the standpoint of the severity of crises. • KEY POINT: All these risks can be observed in advance of the crisis!

10. Recent crises forecasted in particular countries • Mexico: The dog that did not bark in December 1994. • Fiscal spending and bank lending, election year • Overvaluation (Dornbusch) • Bank privatizations, lack of recapitalizations • Recession began in 1993 • Sterilization, reserve outflows, tesobonos liquidity risk • East Asia: Diminishing returns / cronyism • Weak bank balance sheets, high corporate leverage were known • Low or negative return on invested capital due to crony banking • Overvaluation related to declining productivity • Recessions reflecting declining productivity, overvaluation • Brazil: Insufficient fiscal reform • Overvaluation • Old story of unsustainable peg given rising inflation • Argentina: Insufficient fiscal reform • Coparticipation • Labor, tax policies, recession (overvaluation-induced deflation) • Destruction of banking sector

11. Causation in Mexico • Spending, weak privatized banks (Haber article), off-balance sheet exposures raise debt and expected monetization. • As reserves are drained, central bank sterilizers, thereby increasing current money supply. • Rise in money and expected money drive up prices, leading to overvaluation and increasing pressure on exchange rate. • Zedillo’s non-reform leads market to realize inevitability of collapse, and run begins. • FX exposure is combination of direct bets and defaults linked to dollar debt. • Banks double bets on FX by having lots of both (in violation of regs, done with swaps via Wall Street). • Uncanny (forecasted) replay of Chile 1982-83 crisis.

12. Rising Debt, Sterilization

13. Sterilization had been the rule

14. Inflation and base growth linked

15. Inflation increasingly threatened exchange rate

16. Mexican Devaluation

17. Asian Crises • March and April 1997, the Economist and FT have special reports on declining fortunes of Asian banks, and possible crises there. • Alwyn Young writes about declining productivity as threat to sustainability of so-called Asian miracle in 1994-95. • Short-term borrowing in dollars increases as risk rises (largely interbank, “protected”?, and with different weights according to Basel). • IMF assistance bails out those debts.

18. Bank Losses in Asian Crises Thailand Indonesia Korea 1997NPL/TL 19% 17% 16% 1997NPL/GDP 30% 10% 22% Cleanup Cost / 42% 55% 20% 1999 GDP

19. Diminishing Returns => Increasingly Inefficient Capital Investment in East Asia in 1980s, 1990s Return on Capital Employed Minus Interest Rate, 1992 Indonesia -12% Korea - 3% Malaysia 3% Philippines -13% Thailand - 9% Source: Pomerleano (1998)

20. Micro Level Stylized Facts As the 1990s progressed . . . • Asian corporations experienced a decline in performance. • Asian corporate managers increased the leverage of their firms. • Asian corporate managers borrowed substantially from international capital markets in foreign currencies (US Dollars).

21. How Can You Bet the Country? • Government bailouts are anticipated, intermediated by government’s relationship with the IMF, which injects dollars to government, which pays them to crony firms with outstanding short-term debts. • Taxpayers pick up the pieces. • High leverage of ex ante insolvent banks and firms indicates that both borrowers and US, Japanese, and European bank lenders anticipated this. • Note: Capital flows, per se, are not the problem, but rather the allocation of risk by government associated with those flows. There is an argument for waiting to liberalize capital flows until incentives and financial regulation have been fixed. • This is a particularly important issue for China, given that it could repeat the Asian crisis pattern, given diminishing returns and lack of market discipline in banking system.

22. Trends in Corporate Leverage RatiosCountry Comparisons Rating Ratio AAA 13.4 AA 21.9 A 32.7 BBB 43.4 BB 53.9 B 65.9

23. Brazil’s Controlled Devaluation (Healthy banks)

24. Argentina’s Crisis Anticipated Interest Rates on 30-Day Time Deposits in Pesos and Dollars Sources: J.P. Morgan Chase & Co.; Banco Central de la República Argentina, Interest Rates on Deposits (available at http://www.bcra.gov.ar/).

25. Argentina’s Crisis Anticipated Difference Between Interest Rates on 30-Day Time Deposits in Argentina in Pesos and Dollars vs. EMBI+ Argentina Strip Spread Sources: J.P. Morgan Chase & Co.; Banco Central de la República Argentina, Interest Rates on Deposits (available at http://www.bcra.gov.ar/).

26. Deposit Outflows Monthly Dollar Deposits in Argentina, 2001 Source: Argentina Ministry of Economy & Production, Macroeconomic Statistics (available at http://www.mecon.gov.ar/peconomica/basehome/infoeco_ing.html).

27. International Reserve Outflows, 2001 Note: Because of a change in the BCRA’s definition of international reserves, data after October 31, 2001 includes public bonds involved in reverse repo-operations. Data before October 31 does not include these bonds. Source: Banco Central de la República Argentina, International Reserves and BCRA’s Financial Liabilities (available at http://www.bcra.gov.ar/).

28. Annual Capital Inflows by Type Note: Equity inflow was not available until 1992. I use the following variables from the IMF’s International Financial Statistics as components of capital inflows: 1) FDI: line 78bed (Direct Investment in the Reporting Economy, n.i.e.) 2) Equity: line 78bmd (Equity Securities Liabilities) 3) Debt: line 78bnd (Debt Securities Liabilities). 4) Other: line 78bid (Other Investment Liabilities, n.i.e.) Source: International Monetary Fund, International Financial Statistics, June 2004.

29. Argentine Devaluation

30. Role of fixed exchange rates • All of the problems discussed would still be problems under flexible exchange rates • But fixed exchange rates make things worse by create sudden adjustments, and thus big accumulations of risk. • This not only causes sudden problems, it also worsens resurrection risk taking by giving banks and firms something to bet on.

31. Panics vs. Insolvencies • Concern that too much, unwarranted, sudden market discipline can create undesirable social costs from contraction of bank deposits during “panics” is the primary justification for bank safety nets in theory and in history (deposit insurance, and lender of last resort). • Such systemic panics (as distinct from periods of high bank failure) resulted from a combination of observable shocks and unobservable incidence of shocks, in combination with the structure of banks (liquidity transformation, fcfs rule).

32. U.S. Experience with Panics • 1857, 1873, 1884, 1890, 1893, 1896, 1907 • Observable shock was a dual threshold of 9% stock market decline over a quarter, and 50% increase in seasonally adjusted liabilities of failed business (NEWS RELEVANT FOR BANKS) • Some shocks originated in NYC and were related to securities markets, use of funds by NYC banks: In 1857, loans to bond dealers, connections to RRs, was the problem. Some shocks may relate more to peripheral areas (perhaps 1893).

33. Dealing with Panics • Costly bank panics were almost exclusively a U.S. phenomenon by the mid-19th century. Market discipline, along with inter-bank cooperation and lending, central banks, and clearing house actions to share risks dealt with threat of panics effectively, except in U.S. where branching limits, pyramiding of reserves created concentrations of risk, and made coordination difficult. • Desire to keep unit banking, and risk of panics explains why U.S. originates deposit insurance.

34. Dealing with Panics (Cont’d) • Banks assisted each other, sometimes through formal clearing house actions. • Market discipline kept risky banks in check, and made other banks see advantage to identifying and punishing risky banks quickly. • Suspension was used as a last resort, and market discipline created incentives to restore convertibility quickly. • Resumption of convertibility would occur when secondary market discounts on bank paper approached zero.

35. Historical Banking System Collapses • Panics in U.S. did not produce banking collapses, because the combination of market discipline, clearing house support, and temporary suspension of convertibility (until asymmetric information was resolved) insulated banks from costs. • 1893, worst of U.S. panics, coincided with large exogenous agricultural problems, but bank failures produced negative net worth of failed banks of only 0.1% of GDP.

36. Historical Collapses (Cont’d) • Worldwide, from 1873 to 1913, there were no more than seven episodes of severe bank failure worldwide (defined as collapses that produced banking losses where negative net worth of failed banks in a country exceeded 1% of GDP) • Argentina 1890 (~10%), Australia 1893 (~10%), Norway 1900 (~3%), Italy 1893 (~1%), Brazil various (hard to measure, but all much less than 10%). Only 2-3 of these are “twin crises.”

37. Historical Comparison between Today and Pre-WWI Era Appropriate? • 1870s-1913 is a time when capital flows to emerging markets were high relative to GDP, limited liability banking was growing rapidly around the world, countries relied on fixed exchange rates, and macroeconomic climate was very volatile. • This suggests that according to some explanations of crises (exchange rate fixed, free chartering of banks, multiple equilibria due to foreign capital flows) we should see more then than now. But we do not.h

38. Historical Collapses (Cont’d) • Land booms and busts underlay these collapses, and often bank risk was subsidized by government in one way or another. Argentina, Italy subsidized risky bank lending on land; Norway and Australia promoted land booms in other ways. • Banking collapses for some U.S. states also directly traced to safety net policies. Agriculture boom and busts and banking collapses were much more severe in states with deposit insurance (WWI price bets). • Twin crises in Italy and Argentina in 1890s reflected feedback from banking crises to fiscal collapse of government (foreshadowing today’s crises).

39. State-Level Deposit Insurance in 1920s 3 Insured 15 Controls Asset Size $320 $622 Equity / Assets 0.11 0.13 Growth during Boom 185% 128% Loans / Assets 0.76 0.70 Negative NW of fails / Survivors NW 3.5 0.5 Source: Calomiris JEH 1990.

40. How the Safety Net Causes Bank Collapses • Safety net removes market discipline that used to operate, both as a check on conscious risk taking, and on quality of bank management making risk taking decisions. Both effects are important. • These two channels do not operate with constant adverse effects, but rather, their effects vary over the cycle. • Conscious risk taking increases in wake of losses (resurrection bets on unlikely outcomes with high risk premia, especially in currency markets, which deepens extent of twin crises through feedback effects). • Management quality problem can be most hazardous during booms, and becomes visible during busts (WWI grain price bets).

41. Why Few Twin Crises Historically? • Other than those exceptions, fiscal discipline coincided with and reinforced benefits of market discipline over banks. • Governments adhering to gold standard had access to international capital markets, and could act to protect banks with classical lender of last resort liquidity assistance. • Mexico 1907 and Russia 1899-1900 are prime examples of successful assistance • Assistance was limited by credible commitment to stay on gold standard, which in turn ensured access to funds as needed. (Contrast to IMF)

42. What About the Great Depression? • New research (Calomiris and Mason, 1997, 2003) shows that panics were not nationwide phenomenon until very late (early 1933) • For the most part, fundamental shocks (deflationary monetary policy, gold standard, agric. distress, other bad economic policies) caused insolvencies by many banks, not panics. • And, despite the severe shocks and many failures, losses of failed banks 1930-1933 only about 3-4% of GDP.

43. Banking Collapses Today • In contrast, about 150 episodes since 1978 of banking system collapses with costs of more than 1% of GDP, more than 20 with costs in excess of 10% of GDP, and many of those have costs in excess of 20% of GDP. • This is unprecedented. Collapses often coincide with currency collapse due to fiscal implications of banking collapse for government. This reflects changes in political economy of banking systems (similar to Eichengreen 1996 argument on inflation process). • Like Italy and Argentina pre-WWI, these severe collapses have been directly traced to incentives fromgovernment policies protecting banks from market discipline.

44. How Did / Do Disciplined Systems Behave? • Old-Fashioned Disciplined Banking • Equity/Assets and Asset risk managed to target low default risk on debt of bank. During good times, equity capital is cheap (no lemons problems) and lending opportunities are good, so both risk and equity capital rise. • When shock hits, banks face prospect of loss of deposits due to combination of risk aversion and need for liquidity of depositors, and asymmetric information problem about losses within bank. • As banks lose deposits they act to restore confidence by contracting loans, cutting dividends, and expanding cash asset holdings.

45. NYC Bank Capital and Risk 1920-1936

46. NYC Banks’ Loans/Cash, Equity, Dividends Loans/Cash Equity/Assets Dividends 1922 2.1 0.18 1929 3.3 0.33 $392m 1933 1.0 0.15 1940 0.3 0.10 $162m Source: Calomiris-Wilson JB 2004.

47. Discipline Reflected on Liability Side • If discipline exists, it appears in three forms: • Interest cost of debt goes up with risk • Rationing effect: deposits decline • Shift to high-cost, “monitored” marginal funds • These effects are consistently visible historically, as well as currently, in all types of countries. • Bank liability data, and liability interest rate data are the most reliable, consistently reported data on balance sheets, which helps make them especially useful as indicators.

48. Example: Chicago 1932 1932 Failures 1932 Survivors Number 46 62 1931 RD 2% 1% 1931 Borr/Debts 12% 2% 1931 Dep growth -45% -33% Source: Calomiris-Mason 1997 AER.

49. Example: Argentina 1995 1995 Failures 1995 Survivors RD paid in 1993 13% 9.5%

50. Example: Mexico 1996 • Even though there was 100% deposit insurance, the losses were so large, and the political debate so uncertain, that insured deposits were not necessarily protected. • Banamex (marginally solvent) paid 17% on its funds, on average, but Bank Serfin (deeply insolvent) paid 29%